Editor: Annette B. Smith, CPA
Partners & Partnerships
Section 1603 of the American Recovery and Reinvestment Act of 2009, P.L. 111-5 (ARRA), gave Treasury the authority to make payments to reimburse eligible applicants for a portion of expenditures for specified energy property (30% for most projects) used in a trade or business or held for the production of income.
This item discusses whether a partnership should take a partner’s Sec. 743(b) adjustment into account in determining eligible basis of qualified energy property that the partnership has not yet placed in service. (In many cases, a partnership interest is purchased after the partnership places the project in service, but that scenario is not addressed here.) Although there is no specific guidance on this point, certain tax provisions may be helpful in considering the issue.
Note: Applicants receiving Section 1603 payments cannot claim tax credits under Secs. 45 and 48 with respect to the property for the tax year in which the payment is made or any subsequent tax year, and the basis in the property for income tax purposes must be reduced by 50% of the grant amount.
Grant applicants must submit support for the cost basis claimed for the property, with supporting documentation detailing the breakdown of all included costs. For property with basis in excess of $500,000, applicants must submit an independent accountant’s certification attesting to the accuracy of all costs claimed as part of the basis. Applicants are eligible to receive a grant if they are the owner or lessee of the property and originally placed the property in service. Property must be placed in service, defined as being ready and available for its specific use, by December 31, 2011, or placed in service after 2011 but only if construction of the property began during 2009, 2010, or 2011. Applicants for a grant must submit their applications before October 1, 2012.
The legislative history indicates that Section 1603 of ARRA is intended to mimic the Sec. 48 credit rules, which allow investment tax credits (ITCs) equal to the energy percentage of the basis of each energy property placed in service during the tax year (generally 30%). Taxpayers have used various financing structures to take advantage of the energy tax credits under Secs. 45 and 48, including flip partnership (flip) transactions. The flip structure allows smaller companies operating with narrow profit margins and lower tax liabilities to monetize their tax credits and obtain an additional source of financing for a project by allowing a developer to transfer tax credits to an investor who can use them more immediately.
In a typical flip structure, an investor and a developer form an LLC that is treated as a partnership for tax purposes. The investor contributes cash, while the developer generally contributes a project company and equity. Usually, the investor is allocated a majority of the tax benefits from the project (e.g., tax credits and depreciation deductions). Sec. 45 production credits are allocated to the investor (based on the investor’s share of gross revenue) until the investor earns a target rate of return or until the credits expire. The IRS has validated these partnership allocations of Sec. 45 credits by creating a safe harbor in Rev. Proc. 2007-65.
Determination of Eligible Basis
In general, for Section 1603 grant purposes, the eligible basis of property is determined in accordance with the rules for determining the basis of property for federal income tax purposes. Under Sec. 1012, the basis of purchased property is its cost. Usually in the case of a flip partnership structure, the developer forms an LLC to develop the project (the project company). When a tax equity investor makes the initial investment, the ownership of the project company is transferred to a new LLC that becomes a partnership for tax purposes (the flip partnership). The grant applicant is usually the project company that is wholly owned by the flip partnership. Thus, the project company is a disregarded entity owned by the flip partnership.
Treasury guidance provides that the amount of the grant is intended to be equal to the amount of the ITC. Under Sec. 48(a), the ITC is equal to the energy percentage of the basis of energy property. This provision does not indicate whether the eligible basis is the tax basis of the legal entity that holds the property (the project company) or the total basis in the energy property. Thus, it is not clear in the case of the grant whether the eligible basis is limited to the tax basis of the property to the project company or whether any adjustments made by the flip partnership to the basis of energy property also may be taken into account.
A partner’s basis in a partnership interest acquired by purchase is cost basis under Sec. 742. If an investor acquires an interest in a flip partnership prior to the placed-in-service date of qualified energy property, the investor may be entitled to a step-up in the basis of the energy property. Sec. 743(b) provides that the partnership may adjust the basis of its assets (including qualified energy property) to equalize the purchaser’s cost basis (outside basis) with the purchaser’s share of the partnership’s basis in its assets (inside basis), if the partnership has a valid Sec. 754 election in effect. The adjustment is equal to the disparity between the transferee’s basis in the partnership interest (cost) and the transferee’s share of the partnership’s basis in its assets. The depreciation and amortization of the basis adjustment are allocated to the transferee only.
Example 1: A and B are equal partners in partnership P. Each partner contributes $100 in cash, which P uses to develop qualified energy property. P has no liabilities. Two years later, the energy property has basis of $200 and a fair market value of $300. A sells half its interest to C for $75, when P has an election in effect under Sec. 754. C receives a basis adjustment under Sec. 743(b) in the partnership property that is equal to $25, the excess of C’s basis in the partnership interest, $75, over C’s share of the adjusted basis to the partnership of partnership property, $50. Immediately thereafter, the basis in the partnership’s assets ($225) is equal to the partners’ aggregate basis in their partnership interests (A = $50, B = $100, C = $75; total = $225). Regs. Sec. 1.743-1(j)(1) indicates that the basis adjustment is a special basis adjustment that belongs only to the transferee (i.e., the other partners do not benefit from the adjustment). The Sec. 743(b) adjustment is not common basis to the partnership, as $75 of the $225 adjusted basis belongs only to partner C.
Inclusion of Sec. 743(b) Basis Adjustments in Eligible Basis
ARRA refers to certain Code sections, such as Secs. 45 and 48. To what extent should Code sections not specifically identified by either ARRA or Treasury guidance apply? When a partner purchases its interest prior to the placed-in-service date and obtains a Sec. 743(b) basis adjustment in partnership property that otherwise would qualify for the Section 1603 grant, is the adjusted inside basis the appropriate basis to report in the grant application?
Example 2: The facts are the same as in Example 1, but P is a flip partnership that owns 100% of project company PC, LLC. PC purchased qualified energy property with the original $200 contributions by A and B. For federal income tax purposes, P is viewed as owning the purchased property. C purchases half of A’s partnership interest in P for cash and obtains a Sec. 743(b) adjustment before the placed-in-service date. The basis in the partnership’s energy property is increased to $225, but $75 of that basis belongs to C. If PC applies for a Section 1603 grant for this property, is PC’s eligible basis $200 or $225?
The Investment Tax Credit Rules
The ITC rules under Sec. 48(a)(1) provide that the energy credit is the percentage of basis of energy property newly placed in service during a tax year. Sec. 48(a)(3) and Regs. Sec. 1.48-1 further define eligible property, or Sec. 38 property, as property (1) for which depreciation is allowable, (2) that has an estimated useful life of three years or more (determined at time placed in service), and (3) that is tangible personal property or other tangible property. For this purpose, the amount of basis eligible for depreciation is determined under Sec. 167, which provides that depreciable basis is the cost basis of the property.
Arguably, a Sec. 743(b) adjustment to the basis of energy property should be eligible for a Section 1603 grant because it is treated as an increase to the basis of depreciable energy property. Regs. Sec. 1.743-1(a) provides that the basis of partnership property is adjusted as a result of the transfer of an interest in the partnership. A literal reading of Sec. 48(a)(1) suggests that any basis in the energy property is eligible for the ITC. Based on this interpretation, any partnership basis may be eligible for the grant.
The Sec. 743(b) adjustment rules are tied into the depreciation rules, which are referenced in the guidance for the Treasury grant. For Section 1603 grant purposes, the placed-in-service requirements are the same as the requirements under Sec. 168. Regs. Sec. 1.743-1(j)(4) provides that for determining the applicable depreciation method under Sec. 168, if the basis of a partnership’s recovery property is increased as a result of the transfer of a partnership interest, the increased portion of the basis is taken into account as if it were newly purchased recovery property placed in service when the transfer occurs. IRS Letter Rulings 200204006 and 200614019 reflect an IRS position that a Sec. 743(b) adjustment is not a placed-in-service event for purposes of determining low-income housing tax credits. Thus, it may be argued that the Sec. 743(b) adjustment is treated as part of the cost of the property placed in service when the project is placed in service.
There appears to be no guidance in the ITC rules under Sec. 46, 47, or 48 with regard to the inclusion of Sec. 743(b) basis adjustments to the basis of energy property. The Sec. 46, 47, and 48 regulations contain no reference to Sec. 743(b) adjustments, other than in Regs. Sec. 1.48-12(b)(2)(ix), which relates to rehabilitation tax credits. That regulation provides that for purposes of the substantial rehabilitation test only, Sec. 743(b) adjustments are taken into account. Like the energy credit, the rehabilitation credit is an investment credit under Sec. 46, but the reference to Sec. 743(b) adjustments in these regulations is focused narrowly on the substantial rehabilitation test. Arguably, the narrow scope of this rule suggests that Sec. 743(b) adjustments were not considered to be eligible basis.
Regs. Sec. 1.46-3(f) provides that the partnership’s basis in energy property is allocated to the partners, and each partner computes the ITC based on its share of eligible basis. A taxpayer may assert that grant-eligible basis includes the Sec. 743(b) adjustment since the grant rules mimic the ITC rules, and the partners’ share of the basis in the partnership’s energy property includes the Sec. 743(b) adjustment. However, this assertion is questionable because the basis adjustment belongs to the purchasing partner only, and that partner is not the applicant (the project company is the applicant). The Sec. 743(b) regulations indicate that the basis adjustment is a special basis adjustment that belongs only to the transferee (i.e., the other partners do not benefit from the adjustment). Regs. Sec. 1.743-1(j)(1) suggests that the adjustment has no effect on the common basis of the partnership property. The project company files the grant application, not the purchasing partner. In addition, the regulation provides that the basis adjustment is treated as depreciable only when determining the transferee’s income to that adjustment. It is unclear whether a partnership or project company owned by the partnership can include the Sec. 743(b) adjustment in its eligible property basis when that amount really belongs to the purchaser.
However, if the flip partnership became a partnership as a result of the purchase of an interest by an investor, the basis adjustment would be common basis in partnership property. Under Rev. Rul. 99-5, the purchaser is viewed as purchasing property of the project company and then contributing that property to a new partnership that takes a fair market value basis in the property. If the basis adjustment obtained by the partner on the purchased assets under Rev. Rul. 99-5 were grant eligible, it appears that the Sec. 743(b) adjustment obtained when a purchaser acquires an interest in an existing partnership arguably should also be eligible.
Existing guidance for the ITCs sheds no light on whether Sec. 743(b) adjustments could be taken into account when determining eligible basis for property not yet placed in service. However, the program guidance under ARRA provides that the purpose of the grant is to “preserve and create jobs and promote economic recovery in the near term and to invest in infrastructure that will provide long-term economic benefits.” Similarly, according to the history of the legislation that created bonus depreciation, the Job Creation and Worker Assistance Act of 2002, P.L. 107-147, the purpose of bonus depreciation, which recent legislation extended through 2012, is to “accelerate purchases of equipment, promote capital investment, modernization and growth, and . . . help to spur an economic recovery.”
Like the Treasury grants and ITCs, bonus depreciation is determined on the basis of eligible property. The bonus depreciation rules in Regs. Sec. 1.168(k)-1(b)(5)(iii) provide that in the case of a technical termination, the increase in basis of qualified property due to a Sec. 754 election may be eligible for bonus depreciation. Given that bonus depreciation and ITCs have similar congressional purposes, there may be a policy reason for including the Sec. 743(b) adjustment in the eligible basis of energy property when it is included in basis eligible for bonus depreciation. IRS guidance on bonus depreciation released earlier this year (Rev. Proc. 2011-26) does not clarify this issue.
An alternative view is that the inclusion of Sec. 743(b) adjustments may be inconsistent with congressional purpose. For example, if an investor purchases an interest in a partnership that applies for a grant for an alternative energy project, the cash paid to the developer is not necessarily invested in that energy project and may be invested in another grant-eligible project. The inclusion of the Sec. 743(b) adjustment in eligible basis for the first energy project may create an opportunity for the developer to make multiple applications to the Treasury grant program with the same cash investment. It is unclear whether Congress intended this result.
Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington, DC.
For additional information about these items, contact Ms. Smith at (202) 414-1048 or email@example.com.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.